Sustained economic growth depends on the rate at which an economy’s productive capacity grows. Production equals hours worked, multiplied by productivity of labour—the latter measured as the output per unit of labour. Since most workers don’t want longer working hours, an increase in one or both of the remaining variables—employment and productivity—needs to be sustained to maintain our current growth rate.

Two of the challenges we face in India’s labour situation today are skill mismatch and shortage. These, in turn, can hamper both employment as well as productivity growth, especially in human-capital intensive industries, and undermine the economy’s growth potential going forward.

What drives labour productivity? Growth in this context is explained by three factors—more capital per unit of labour, technological advance and the quality of human capital. Interactions between these factors determine the marginal product of labour—the increase in output due to one more labour unit.

What would happen if good quality labour were in short supply? In a competitive labour market, excess demand for skilled workers puts upward pressure on wages. This, in turn, stimulates an increase in the supply of skilled workers, thereby eliminating the shortage.

However, the supply of skilled labour cannot be increased overnight. In the intermediate period, if relatively low-quality new labour brings down the average quality of the workforce, productivity growth will suffer even if technology continues to improve and capital is accumulated at a rapid pace. What would be the use of new technology and greater capital intensity if the labour force does not have the necessary skills to exploit them?

There is no doubt that the average educational attainment of our workforce has gone up in recent years. However, there continues to be a shortage of skilled manpower relative to its demand in industries such as financial services. Even in industries where there is no shortage of workers with the essential technical qualifications, many of them lack qualities that firms consider important.

Formal education only certifies that a person has a minimum qualification to undertake a particular job. However, many candidates do not possess other qualities desired by employers, such as the ability to apply formal education in practice, and relevant experience.

The National Sample Survey data suggests that the unemployment rate for youth with degree-level education was around 20% in urban areas in 2007-08. More critically, data for 2004-05 suggests that for the category of people who had undertaken some sort of formal vocational training—the much-neglected sphere in the Indian education system—the unemployment rate was around 26%.

It is unlikely that there would not have been sufficient employment opportunities for people with vocational training. Rather, it appears likely that a number of them would not have been able to get past the scrutiny of employers in terms of required skills, despite having the necessary educational qualifications.

Such skill shortages not only increase the cost of hiring, but also tilt the composition of the workforce towards relatively low-skilled workers. Moreover, companies’ bargaining power with existing skilled employees is severely restricted under such circumstances.

In practice, firms not only have difficulties in recruiting skilled workers, but also face an internal skill gap—the difference between existing skill levels of current employees and their desired level of skills. This gap impedes firms from achieving their business objectives. For examples, delays in developing new products, which may not have an immediate impact on corporate performance, can nonetheless affect future profitability.

If skill gaps in the current workforce are significant, firms will avoid investing in new technologies, since these cannot be fully exploited. This would, in turn, result in less differentiated and relatively lower quality products. What can be done to improve the skills of the existing workforce? Training is just as important as initial education. Though many Indian companies have realized its importance, much more needs to be done on this front.

At present, Indian companies face both internal skill gap and external skill shortage. Of course, many other emerging countries also face similar problems, but some of them seem to be doing more to address this issue. For example, in its fiscal stimulus package after the recent global economic crisis, the government of Indonesia undertook measures to support vocational training as part of its drive to upgrade workers’ skills and employability. Similar policies have also been followed by Singapore.

The Indian economy is relatively more dependent on human capital than other countries at a similar level of development. If employment in skill-intensive industries cannot be raised fast enough due to skill shortages, the average labour productivity growth may not be sustained.

In addition, to sustain the current growth rate, existing skilled workers would have to put in longer hours, which could adversely affect their productivity. In a nutshell, labour productivity growth in India could witness a downturn in coming years.

If this were to happen, the irony would be that a country which cannot find enough people with relevant skills, would also be one that is set to become the largest contributor to the global workforce over the next couple of decades.